Bond Bounce Is a Bearish Opportunity

Think TLT is riding a paper bull? Consider this spread option

The money fleeing equities during the past three days appears to be finding its way into the safe harbors of U.S. Treasurys. The popular iShares Barclays 20+ Year Treasury ETF (NYSE:TLT) is up 3.5% since hammering out its lows on Tuesday morning.

While some might contend this marks the beginning of yet another sustained rise in bonds, I remain unconvinced. With the TLT breaking the pivotal 50-day moving average earlier in the month and potentially entering an intermediate downtrend, the current rise is thus far an oversold bounce, nothing more.

Click to Enlarge Traders agreeing that the path of least resistance for TLT is likely sideways to down ought to be using the current rally as an opportunity to enter strategies like a bear call spread.

This bearish vertical spread consists of selling a lower-strike call while buying a higher-strike call in the same expiration month. Typically, somewhat shorter-dated options are used to exploit the higher rate of time decay. Traders also use out-of-the-money options to setup a high-probability trade that profits even if the stock moves sideways or slightly higher.

With TLT trading at $125, traders could sell the Oct 128 call and buy the 133 call for a net credit of 67 cents. The max reward is limited to the initial $67 received at trade inception and will be captured provided TLT remains below $128 by October expiration. The risk is capped at the distance between strikes (133-128 = 5) minus the net credit (5 – 0.67 = 4.33) and will be incurred if TLT rises above $133 by Oct expiration.

In the event TLT continues to rise, traders might consider closing the trade if we reach the short strike price ($128) to limit losses.

As of this writing, Tyler Craig did not hold a position in any of the aforementioned securities.